Predetermined overhead rates are a crucial tool in managerial accounting. They allow companies to estimate and apply overhead costs to products before the actual costs are known, enabling timely decision-making and consistent cost reporting throughout the period.
The process involves calculating a rate based on estimated costs and activity levels, then applying it to actual production. This method smooths out cost fluctuations, simplifies overhead allocation, and facilitates cost analysis and pricing decisions.
Predetermined Overhead Rates and Application
Predetermined overhead rate calculation
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Estimates total overhead costs and activity base before the period begins
Enables timely reporting and decision making throughout the period
Evens out overhead cost fluctuations (seasonal variations, production volume changes)
Predetermined overhead rate formula: Estimated total overhead costs Estimated total units in the allocation base \frac{\text{Estimated total overhead costs}}{\text{Estimated total units in the allocation base}} Estimated total units in the allocation base Estimated total overhead costs
Allocation base measures activity driving overhead costs (direct labor hours, machine hours, units produced)
Determines overhead cost per unit of activity (rate per direct labor hour, rate per machine hour)
Calculating predetermined rate example:
Estimated overhead costs: $100,000
Estimated direct labor hours: 5,000
Predetermined rate: 20 p e r d i r e c t l a b o r h o u r ( 20 per direct labor hour ( 20 p er d i rec tl ab or h o u r ( 100,000 / 5,000 hours)
Overhead application to production
Applies overhead costs to products or services using predetermined rate and actual activity level
Assigns a portion of overhead costs to each unit produced
Calculates total production cost (direct materials + direct labor + applied overhead )
Applied overhead formula: \text{[Predetermined overhead rate](https://www.fiveableKeyTerm:Predetermined_Overhead_Rate)} \times \text{Actual activity level}
Multiplies predetermined rate by actual activity consumed (actual direct labor hours worked, actual machine hours used)
Applying overhead example:
Predetermined rate: $20 per direct labor hour
Actual direct labor hours: 4,800
Applied overhead: 96 , 000 ( 96,000 ( 96 , 000 ( 20 × 4,800 hours)
Adds $96,000 to total production cost for the period
Rationale for predetermined rates
Actual overhead costs unknown until period ends
Using actual costs delays reporting and decision making
Hinders timely cost control and variance analysis
Predetermined rates enable timely reporting and management
Allows comparing applied overhead to actual overhead costs throughout period
Identifies variances for investigation (over-applied overhead or under-applied overhead )
Smooths overhead cost fluctuations over time
Provides more consistent unit costs (avoids extreme high or low costs due to volume changes)
Aids in pricing and budgeting decisions
Simplifies overhead cost allocation to products or jobs
Avoids tracking actual overhead costs consumed by each product (time-consuming, complex)
Applies overhead based on readily available activity measures (direct labor hours, machine hours)
Facilitates cost-volume-profit analysis by providing consistent overhead costs
Costing Methods
Normal costing : Uses predetermined overhead rates and actual direct costs
Actual costing : Uses actual overhead and direct costs, but delays reporting
Activity-based costing : Assigns overhead based on multiple cost drivers for more accurate product costing